nep-ifn New Economics Papers
on International Finance
Issue of 2005‒02‒13
twenty papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Real Equilibrium Exchange Rate in China By Virginie Coudert; Cecile Couharde
  2. The Purchasing Power Parity Debate By Taylor, Mark P; Taylor, Alan M
  3. Purchasing Power Parity and the Euro Area By Koedijk, Kees; Tims, Ben; Van Dijk, Mathijs A
  4. Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows and Exchange Rates? By Hau, Harald; Rey, Hélène
  5. A Guided Tour of the Market Microstructure Approach to Exchange Rate Determination By Vitale, Paolo
  6. Monetary Policy in an Estimated Open-Economy Model with Imperfect Pass-Through By Lindé, Jesper; Nessen, Marianne; Söderström, Ulf
  7. Exchange Rates and Inflation Under EMU: An Update By Honohan, Patrick; Lane, Philip R.
  8. An Empirical Study of Liquidity and Information Effects of Order Flow on Exchange Rates By Breedon, Francis; Vitale, Paolo
  9. External Currency Pricing and the East Asian Crisis By Cook, David; Devereux, Michael B
  10. Monetary and Exchange Rate Policy in Korea: Assessments and Policy Issues By Eichengreen, Barry
  11. Financial Globalization and Exchange Rates By Lane, Philip R.; Milesi-Ferretti, Gian Maria
  12. The Rise of Fund Managers in Foreign Exchange By Gehrig, Thomas; Menkhoff, Lukas
  13. Caution or Activism? Monetary Policy Strategies in an Open Economy By Ellison, Martin; Sarno, Lucio; Vilmunen, Jouko
  14. Inflation Persistence and Exchange Rate Regimes: Evidence from Developing Countries By Manuela Francisco; Michael Bleaney
  15. Is the exchange rate a shock absorber or a source of shocks? New empirical evidence By K. FARRANT; G. PEERSMAN
  16. The relative importance of symmetric and asymmetric shocks and the determination of the exchange rate By G. PEERSMAN
  17. The Fit of Dynamic Equilibrium Models of Exchange Rate By Juan Ángel Jiménez Martín; Rafael Flores de Frutos
  18. Macroeconomic and policy uncertainty and Exchange rate risk Premium By Juan Ángel Jiménez Martín; Rodrigo Peruga Urrea
  19. Seasonal Fluctuations and Dynamic Equilibrium Models of Exchange Rate By Juan Angel Jiménez Martín; Rafael Flores de Frutos
  20. Balance of Payments Constrained Growth Model: The Case of India By Arslan Razmi;

  1. By: Virginie Coudert; Cecile Couharde
    Abstract: In this paper, we try to measure the size of a possible misalignment in the Chinese real exchange rate by two ways. On one hand, we address the issue of the “Balassa effect”, by which the real exchange rate of a catching-up country should appreciate. We compare China with other emerging countries, in order to assess the size of a “normal” “Balassa effect”. On the other hand, we follow the FEER (Fundamental Equilibrium Exchange Rate) approach. We use the NIGEM model for representing the foreign trade of China, the United States, the Euro area, South Korea and Japan. We calculate the real effective exchange rate that is consistent with sustainable current accounts. Both methods yield an undervaluation of the renminbi.
    Keywords: renminbi; Balassa effect; BEER; FEER
    JEL: F31 F33
    Date: 2005–01
  2. By: Taylor, Mark P; Taylor, Alan M
    Abstract: Originally propounded by the 16th-century scholars of the University of Salamanca, the concept of purchasing power parity (PPP) was revived in the interwar period in the context of the debate concerning the appropriate level at which to re-establish international exchange rate parities. Broadly accepted as a long-run equilibrium condition in the post-war period, it first was advocated as a short-run equilibrium by many international economists in the first few years following the breakdown of the Bretton Woods system in the early 1970s and then increasingly came under attack on both theoretical and empirical grounds from the late 1970s to the mid 1990s. Accordingly, over the last three decades, a large literature has built up that examines how much the data deviated from theory, and the fruits of this research have provided a deeper understanding of how well PPP applies in both the short run and the long run. Since the mid 1990s, larger datasets and nonlinear econometric methods, in particular, have improved estimation. As deviations narrowed between real exchange rates and PPP, so did the gap narrow between theory and data, and some degree of confidence in long-run PPP began to emerge again. In this respect, the idea of long-run PPP now enjoys perhaps its strongest support in more than 30 years, a distinct reversion in economic thought.
    Keywords: exchange rates; long-run equilibrium; nonlinearity; purchasing power parity; real exchange rates
    JEL: F31 F41
    Date: 2004–07
  3. By: Koedijk, Kees; Tims, Ben; Van Dijk, Mathijs A
    Abstract: This Paper analyses purchasing power parity (PPP) for the euro area. We study the impact of the introduction of the euro in 1999 on the behaviour of real exchange rates. We test the PPP hypothesis for a panel of real exchange rates within the euro area over the period 1973-2003. Our methodology exploits the cross-sectional dependence across real exchange rates and allows for heterogeneity in the rates of mean reversion. We present evidence in favour of PPP for the full panel of real exchange rates, but we show that accounting for cross-country differences within the euro area is essential. The unit root hypothesis can be rejected for some real exchange rates, but evidence for PPP is weak for others. We also investigate PPP between the ‘synthetic’ euro against several other major currencies over the period 1979-2003. We find support for the PPP hypothesis for the full panel of real exchange rates. When the restriction of a common mean reversion coefficient is relaxed, we reject the unit root hypothesis for the euro-Swiss franc rate only. We conclude that the process of economic integration in Europe has accelerated convergence toward PPP within the euro area.
    Keywords: european integration; heterogenous SUR; purchasing power parity; real exchange rates
    JEL: F31 F33 G15
    Date: 2004–07
  4. By: Hau, Harald; Rey, Hélène
    Abstract: We explore whether the pattern of international equity returns, equity portfolio flows, and exchange rate returns are consistent with the hypothesis that (unhedged) global investors rebalance their portfolio in order to limit their exchange rate exposure when there are (1) relative equity return; and (2) exchange rate shocks. We also explore whether (3) equity flow shocks influence the exchange rates and relative equity prices. In the estimation of the VAR system we do not impose any causal ordering upon the primitive shocks, but instead identify the system based on theoretical priors about the contemporaneous conditional correlations between the three variables. International data for the five largest equity markets are consistent with a theory in which equity returns and portfolio rebalancing are an important source of exchange rate dynamics.
    Keywords: F37; international finance
    JEL: F30 F31
    Date: 2004–08
  5. By: Vitale, Paolo
    Abstract: We propose a critical review of recent developments in exchange rate economics. This new strand of research is motivated by some very stark empirical evidence, relating exchange rate returns to order flow. Plenty of empirical evidence shows that order flow, i.e. the imbalance in the sequence of purchases and sales of foreign currencies in the markets for foreign exchange, is an extremely powerful determinant of short-run exchange rate movements. With a simplified analytical framework we see how, according to the rational expectation paradigm of asset pricing, such a relation reflects liquidity and information effects of portfolios shifts.
    Keywords: exchange rate dynamics; foreign exchange microstructure; order flow
    JEL: D82 G14 G15
    Date: 2004–08
  6. By: Lindé, Jesper; Nessen, Marianne; Söderström, Ulf
    Abstract: We develop a structural model of a small open economy with gradual exchange rate pass-through and endogenous inertia in inflation and output. We then estimate the model by matching the implied impulse responses with those obtained from a VAR model estimated on Swedish data. Although our model is highly stylized it captures very well the responses of output, domestic and imported inflation, the interest rate, and the real exchange rate. In order to account for the observed persistence in the real exchange rate and the large deviations from UIP, however, we need a large and volatile premium on foreign exchange.
    Keywords: calibration; estimation; new open-economy macroeconomics; structural open-economy model
    JEL: E52 F31 F41
    Date: 2004–08
  7. By: Honohan, Patrick; Lane, Philip R.
    Abstract: In our recent Economic Policy article (Honohan and Lane, 2003), we argued that the strength of the US dollar 1999-2001 had an important impact on inflation divergence within the EMU and in particular the surge in Ireland’s inflation to over 7%. This hypothesis has been subjected to a grueling out-of-sample test: would the dollar’s subsequent weakness contribute to inflation convergence and in particular to a fall in Irish inflation? Fortunately for us, the theory has passed the test with flying colours. Irish inflation stopped dead in its tracks: consumer prices were unchanged between May and November of 2003. Regression analysis on quarterly inflation data across EMU members 1999.1-2004.1 confirms the importance of the exchange rate channel, although pinning down the exact dynamic specification will require a further span of data.
    Keywords: EMU; exchange rates; inflation
    JEL: E31 E42 F41
    Date: 2004–08
  8. By: Breedon, Francis; Vitale, Paolo
    Abstract: We propose a simple structural model of exchange rate determination that draws from the analytical framework recently proposed by Bacchetta and van Wincoop (2003) and allows us to disentangle the liquidity and information effects of order flow on exchange rates. We estimate this model employing an innovative transaction data-set that covers all direct foreign exchange transactions completed in the USD/EUR market via EBS and Reuters between August 2000 and January 2001. Our results indicate that the strong contemporaneous correlation between order flow and exchange rates is mostly due to liquidity effects. This result also appears to carry through to the four FX intervention events that appear in our sample.
    Keywords: exchange rate dynamics; foreign exchange mirror structure; order flow
    JEL: D82 G14 G15
    Date: 2004–08
  9. By: Cook, David; Devereux, Michael B
    Abstract: This Paper provides a quantitative investigation of the East Asian crisis of 1997-99. There are two essential features of the crisis that we focus on. These are: a) the crisis was a regional phenomenon; the depth and severity of the crisis was exacerbated by a large decline in regional demand; and b) the practice of setting export goods prices in dollars (which we document empirically) led to a powerful internal propagation effect of the crisis within the region, contributing greatly to the decline in regional trade flows. We construct a multicountry macroeconomic model with these two features, and show that it can do a reasonable job of accounting for the response of the main macroeconomic aggregates in Korea, Malaysia, and Thailand during the crisis. Without the regional dimension and dollar pricing of exports, the model fails to account for the depth and severity of the crisis.
    Keywords: east asian crisis; exchange rate; small open economy
    JEL: F40
    Date: 2004–09
  10. By: Eichengreen, Barry
    Abstract: This Paper considers monetary and exchange rate policy in Korea since the financial crisis of 1997-98. The Bank of Korea has adopted much of the apparatus of inflation targeting, with a band for target inflation and a Monetary Policy Report to the National Assembly. This regime has served the country well. But neither the Bank’s publications nor the statements of its Monetary Policy Committee make more than passing reference to the exchange rate. It would be surprising if in fact the exchange rate played little role in conduct of monetary policy, for in an economy as open and sensitive to foreign trade and investment as Korea, currency movements contain information useful for forecasting inflation and the output gap. My findings suggest that the Bank of Korea does care about the exchange rate – and not only because it movements provide information relevant for the inflation forecast. In addition, the central bank responds to movements in the exchange rate for other reasons, like its implications for the balance of investment in traded and nontraded goods and its implications for financial stability. My recommendations are thus for more clarity on the role of the exchange rate in the formulation and conduct of monetary policy. In particular, if the members of the Monetary Policy Committee are attentive to exchange rate movements, which is what is suggested by the evidence presented here, and especially if they care about such movements for reasons not limited to the utility of that variable for forecasting future inflation, then they should acknowledge this in their monthly press releases communicating the rationale for their decisions to the public and the markets.
    Keywords: exchange rate; inflation targeting; monetary policy; South Korea
    JEL: F10
    Date: 2004–10
  11. By: Lane, Philip R.; Milesi-Ferretti, Gian Maria
    Abstract: The founders of the Bretton Woods System sixty years ago were primarily concerned with orderly exchange rate adjustment in a world economy that was characterized by widespread restrictions on international capital mobility. In contrast, the rapid pace of financial globalization during recent years poses new challenges for the international monetary system. In particular, large gross cross-holdings of foreign assets and liabilities means that the valuation channel of exchange rate adjustment has grown in importance, relative to the traditional trade balance channel. Accordingly, this Paper empirically explores some of the inter-connections between financial globalization and exchange rate adjustment and discusses the policy implications.
    Keywords: capital flows; external assets and liabilities; financial integration
    JEL: F31 F32
    Date: 2004–11
  12. By: Gehrig, Thomas; Menkhoff, Lukas
    Abstract: This Paper analyses the behaviour and motivation of fund managers in foreign exchange markets reflected in questionnaire evidence. We find that fund managers and FX dealers differ significantly. Fund managers rely more on fundamentals, basically due to their longer forecasting horizons, and reject non-fundamental influences on exchange rates more than FX dealers. Neither can fund managers be considered as pure fundamentalists, however. Non-fundamentalist positions markedly influence short-term decision-making. They inspire ambivalent views about market imperfections and these views seem to become stronger over time. This latter change counterbalances the strengthening fundamental influences resulting from the rise of fund managers.
    Keywords: foreign exchange; fund management; fundamentals; market microstructure
    JEL: F31 G23
    Date: 2004–10
  13. By: Ellison, Martin; Sarno, Lucio; Vilmunen, Jouko
    Abstract: We examine optimal policy in a two-country model with uncertainty and learning, where monetary policy actions affect the real economy through the real exchange rate channel. Our results show that whether policy should be cautious or activist depends on the size of one country relative to another. If one country is small relative to the other then activism is optimal. In contrast, if the two countries are equal sized then caution prevails. Caution is induced in the latter case because of the interaction between the home and foreign central banks. In a two-country symmetric equilibrium, learning is shown to be detrimental to welfare, implying that optimal policy is cautious.
    Keywords: learning; monetary policy; open economy
    JEL: E52 E58 F41
    Date: 2004–11
  14. By: Manuela Francisco (Universidade do Minho); Michael Bleaney (University of Nottingham)
    Abstract: Using data for 102 developing countries, it is shown that inflation persistence is particularly high in countries with severe inflationary problems, and particularly low in countries on hard pegs. Inflation persistence is similar under floating and soft pegs.
    Keywords: Inflation, persistence, exchange rates
    JEL: E31 F41
    Date: 2005
    Abstract: This paper analyses the role of the real exchange rate in a structural vector autoregression (sVAR) framework for the United Kingdom, Euro area, Japan and Canada vis-á-vis the United States. A new identification strategy is proposed building on sign restrictions. The results are compared to the benchmark conventional approach of Clarida and Gali (1994) based on long-run zero restrictions. Although the restrictions are derived from the same theoretical model, the results are strikingly di??erent. In contrast to the benchmark model, an important role for nominal shocks in explaining real exchange rate fluctuations is found. Hence, the exchange rate can rather be considered as a source of shocks instead of a shock absorber.
    Keywords: exchange rates, vector autoregressions
    JEL: C32 E42 F31 F33
    Date: 2005–01
  16. By: G. PEERSMAN
    Abstract: This paper shows how sign restrictions can be used to identify symmetric and asymmetric shocks in a simple two-country structural VAR. Specifically, the e??ects of symmetric and asymmetric supply, demand and monetary policy shocks as well as pure exchange rate shocks are estimated. The results can be used to deal with two issues. First, it is possible to estimate the relative importance of symmetric, asymmetric and pure exchange rate shocks across two countries or areas, which provides information about the degree of business cycle synchronization. Second, it is also possible to evaluate the relative importance of these shocks in determining exchange rate fluctuations, which can deliver answers to questions like ’Is the exchange rate a shock absorber or source of shocks?’. Evidence is provided for the UK versus the Euro area and compared with the US as a benchmark.
    Keywords: exchange rates, symmetric and asymmetric shocks, vector autoregressions
    JEL: C32 E42 F31 F33
    Date: 2005–01
  17. By: Juan Ángel Jiménez Martín (Universidad Complutense de Madrid. Facultad de CC. Económicas y Empresariales. Dpto. de Fundamentos de Análisis Económico II.); Rafael Flores de Frutos (Universidad Complutense de Madrid. Facultad de CC. Económicas y Empresariales. Dpto. de Fundamentos de Análisis Económico II.)
    Abstract: The two-country monetary model has become a fundamental tool for explaining the behavior of the exchange rate. However, the popularity of this approach is not justified by its empirical support. One of the reasons for the empirical “failure” of exchange rate models could be the econometric approach applied. In this paper, an alternative procedure for evaluating the fit of dynamic equilibrium models of exchange rate is suggested. This approach is applied to three theoretical models: Lucas (1982), Svensson (1985), and Grilli and Roubini (1992).
    Date: 2004
  18. By: Juan Ángel Jiménez Martín (niversidad Complutense de Madrid. Facultad de CC. Económicas y Empresariales. Dpto. de Fundamentos de Análisis Económico II.); Rodrigo Peruga Urrea (niversidad Complutense de Madrid. Facultad de CC. Económicas y Empresariales. Dpto. de Fundamentos de Análisis Económico II.)
    Abstract: The goal of this paper is to identify the main determinants of the risk premium in some European currency markets just before the EMU. To that extent, we start from Lucas (1982) exchange rate model and derive an analytical expression for the forward premium. This expression includes money and production variables and it is quite standard, except for the inclusion of macroeconomic policy risk. Under some standard assumptions, this formula simplifies substantially and becomes amenable to regression analysis. Then, using standard measures of money and production, as well as interest rate swap spreads as indicators of macroeconomic policy risk, the theoretical expression is estimated. We provide evidence suggesting that it is policy uncertainty, much more than fundamental macroeconomic uncertainty, which determined risk premium over the convergence process to the euro. Whether these results can be extended to similar experiences for other currency unions remains open for future research.
    Date: 2004
  19. By: Juan Angel Jiménez Martín (Universidad Complutense de Madrid. Facultad de CC. Económicas y Empresariales. Dpto. de Fundamentos de Análisis Económico II.); Rafael Flores de Frutos (Universidad Complutense de Madrid. Facultad de CC. Económicas y Empresariales. Dpto. de Fundamentos de Análisis Económico II.)
    Abstract: Most dynamic equilibrium models of exchange rate are not able to generate monthly time series with the typical properties of actual exchange rate. If the exogenous endowments in an equilibrium exchange rate model contain seasonal variations, then the exchange rate will as well. In this paper, we show how in this framework, seasonal preferences can help to remove seasonality of the exchange rate simulated time series.
    Date: 2004
  20. By: Arslan Razmi (University of Massachusetts Amherst);
    Abstract: This study applies the Balance of Payments Constrained Growth (BPCG) model to India, a large developing country with a relatively low trade to GDP ratio. Rather than assuming similar elasticities of substitution between goods produced in different regions, the study extends the model to relax these assumptions. Johansen’s cointegration technique is employed to estimate trade parameters. Short-run adjustments are explored within a vector error correction framework. The average growth rates predicted by various forms of the BPCG hypothesis are found to be close to the actual average growth rate over the period 1950-1999, although individual decades display substantial deviations. JEL Categories: F43, F14, E12
    Keywords: Balance of payments-related constraints, real exchange rates, Johansen’s cointegration technique, strong form, weak form, trade multiplier, import compression.
    Date: 2005–02

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